Pricing Risk in Economies with Heterogenous Agents and Incomplete Markets
Abstract
Habit formation has been proposed as a possible solution for explaining the equity premium puzzle. This paper extends the class of models that support the habits explanation in order to account for heterogeneity in earnings, wealth, habits and consumption. I find that habit formation increases the equity premium. However, contrary to the earlier results in the literature, the habit hypothesis does not imply a price for risk much higher than the one implied by models with intertemporally separable preferences. The main reasons for this are general equilibrium ones. First, with just two assets available, households can smooth out consumption fluctuations very well. Therefore, the higher utility losses of uncertainty imposed by habits will not command a high price of risk because households manage to avoid this risk. Second, the composition of the set of agents pricing the assets is sensitive to changes in the model. In an economy with habits, pricing agents turn out to be households facing very small consumption fluctuations. In addition I characterize three important properties of the model economy that relate to portfolio choice: willingness to hold risky assets (1) increases with wealth, (2) decreases with labor earnings and (3) decreases with habit stock.Download Info
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Paper provided by Centro de Altisimos Estudios Rios Perez (CAERP) in its series Centro de Altisimos Estudios Rios Pe©rez(CAERP) with number 3.Length: 38 pages
Date of creation: Dec 2002
Date of revision:
Handle: RePEc:cae:caerpp:3
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Related research
Keywords: Equity Premium; Habit Formation; Incomplete Markets;Other versions of this item:
- Josep Pijoan-Mas, 2007. "Pricing Risk in Economies with Heterogeneous Agents and Incomplete Markets," Journal of the European Economic Association, MIT Press, vol. 5(5), pages 987-1015, 09.
- Pijoan-Mas, Josep, 2006. "Pricing Risk in Economies with Heterogenous Agents and Incomplete Markets," CEPR Discussion Papers 5602, C.E.P.R. Discussion Papers.
- D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- E21 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
- C68 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computable General Equilibrium Models
This paper has been announced in the following NEP Reports:
- NEP-ALL-2003-05-15 (All new papers)
- NEP-DGE-2003-05-15 (Dynamic General Equilibrium)
- NEP-FIN-2003-05-15 (Finance)
- NEP-MAC-2003-05-15 (Macroeconomics)
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Citations
Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.Cited by:
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